With the improving economy we seem to be witnessing an uptick in the sale and purchase of small and medium-sized businesses. Banks are lending once again and potential buyers are more optimistic about the future of our economy. Sale of business transactions virtually ground to a halt in 2011, with banks generally unwilling to lend; without bank financing, potential buyers sat on the sidelines and even motivated sellers were prevented from selling. We hope that all of that is now behind us.
When contemplating the purchase of a business there are several critical issues which must be considered:
- Price/Valuation. Setting the price of a business is part science and part educated-guess. A business can be valued in many ways, but most commonly the value of a business is determined as a function of its earnings and earning potential. Typically the annual earnings of a successful business will be capitalized using an accepted capitalization rate (interest factor) to arrive at a value for the business. Since this type of valuation is based upon the earnings of the business, a buyer’s accountant will typically adjust the earnings (sometimes called normalization) to make certain that all income and expenses are properly recognized in arriving at the final earnings figure.
- Financial Due Diligence. In addition to determining a proper value for the business, a potential buyer must carefully review the seller’s business records over the past several years to understand the business and profitability trends of the enterprise. Inconsistencies from year to year must be explained by the seller. The buyer must gain an understanding of precisely how the seller makes its money and determine the vulnerability of the business to adverse changes in the future. Relationships with suppliers and customers must be understood. Key employees must be identified and retained. Favorable contracts and leases must be identified and preserved or extended. Comprehensive due diligence is critical to the success of the business acquisition.
- Financing the Purchase. The three major choices here are self-financing, bank-financing and seller-financing. Often a transaction will include all three in different proportions. Most banks will not make a loan to a buyer if the buyer is not also investing in the business. If a bank is willing to commit a loan for 80% of the purchase price, the buyer must still come up with the remaining 20%. This can come partly from the buyer’s own funds, and possibly from having the seller take back a note for the balance of the price.
- Structure. Business acquisitions are usually structured either as a sale of the shares of stock (or LLC interests) of the business or as a sale of the business assets to the buyer. Buyers almost always prefer to purchase the assets from the business rather than purchasing the entity which operates the business. This is because purchasing the assets of the business is usually more favorable from a tax standpoint and largely eliminates the possibility of the buyer having liability to the seller’s creditors after the sale.
- Employment Agreements and Non Competes. On the one hand, a buyer should consider entering into written employment agreements with the key employees of the business to make certain they continue working after the sale. On the other hand, the buyer should also consider having the seller enter into a “non compete” agreement to prevent the seller from competing with the buyer after the sale. These are customary terms of an asset purchase agreement.
The purchase of a business can be both exciting and stressful. The buyer’s attorney and accountant play a critical role in ensuring that the buyer pays a fair price for the business and is protected after the sale. Give us a call if we can help you in this area.
— Kevin Palmer